Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that Tao Heung Holdings Limited (HKG:573) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Tao Heung Holdings's Debt?
The image below, which you can click on for greater detail, shows that Tao Heung Holdings had debt of HK$128.7m at the end of June 2019, a reduction from HK$140.1m over a year. However, it does have HK$567.4m in cash offsetting this, leading to net cash of HK$438.7m.
How Healthy Is Tao Heung Holdings's Balance Sheet?
The latest balance sheet data shows that Tao Heung Holdings had liabilities of HK$819.3m due within a year, and liabilities of HK$716.7m falling due after that. On the other hand, it had cash of HK$567.4m and HK$63.7m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$905.0m.
This deficit is considerable relative to its market capitalization of HK$1.35b, so it does suggest shareholders should keep an eye on Tao Heung Holdings's use of debt. This suggests shareholders would heavily diluted if the company needed to shore up its balance sheet in a hurry. While it does have liabilities worth noting, Tao Heung Holdings also has more cash than debt, so we're pretty confident it can manage its debt safely.
On top of that, Tao Heung Holdings grew its EBIT by 70% over the last twelve months, and that growth will make it easier to handle its debt. There's no doubt that we learn most about debt from the balance sheet. But it is Tao Heung Holdings's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While Tao Heung Holdings has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the last three years, Tao Heung Holdings actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
Although Tao Heung Holdings's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of HK$439m. And it impressed us with free cash flow of HK$176m, being 132% of its EBIT. So we don't think Tao Heung Holdings's use of debt is risky. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that Tao Heung Holdings insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.